Strong Brew at Caremark

Rivals Medco and Express Scripts look solid heading into earnings.
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Caremark's

(CMX)

growth formula continues to work.

The company's focus on generic drugs and mail-order prescriptions pushed fourth-quarter profit up 22% to 55 cents a share, matching Wall Street expectations for the period. Revenue of $8.4 billion, up 4% from a year ago, topped the consensus estimate. Meanwhile, the company's newly tightened 2006 guidance of $2.33 to $2.38 a share now rests comfortably ahead of most analyst forecasts.

Caremark's stock climbed 82 cents to $49.83 on the positive update.

By now, of course, investors have come to expect plenty from the giant pharmacy benefit managers. They had their eyes on Caremark, as the first of the so-called Big Three to report earnings, in search of evidence that the sector's impressive rally could continue. On Wednesday,

Express Scripts

(ESRX)

dropped 51 cents to $91.32 a week before its own quarterly report, and

Medco

(MHS)

rose 45 cents to $55.52 ahead of an earnings report next month.

All three PBMs have seen their successful business models challenged by calls for change in the highly secretive industry. They have been accused of pocketing excess rebates on brand-name drugs and, more recently, capitalizing on big pricing spreads for generics. In the meantime, they have already started losing contracts to some more transparent players outside their own circle.

JP Morgan analyst Lisa Gill, who ranks as one of Caremark's biggest fans, recently acknowledged this shift even as she portrayed PBMs as solid long-term investments. Her firm counts all three of the major PBMs among its clients.

"Generally, top-line growth has moderated for the PBMs in recent quarters, due to a number of factors -- including slower script growth due to product safety concerns and the impact of generics, as well as contract shifts outside of the big three," Gill wrote on Monday. But "growth rates at each individual PBM are driven largely by company-specific events. ... We believe stock selection in the PBM segment will continue to be the key to outperformance and recommend Caremark and Medco as the two names to own in the group" going into earnings season.

The Bright Side

Still, William Blair analyst John Kreger characterized Caremark's latest results as little more than "in line" with expectations.

Indeed, Kreger noted that the company actually fell short of his own forecasts on a couple of key metrics. He mentioned the company's gross profit rate, along with its profitability per adjusted claim, in particular.

At the same time, however, Kreger stressed that Caremark's gross profit rate had -- once again -- shown year-over-year improvement. He also portrayed the company's lowered revenue guidance as a potential positive, saying that it could signal growing penetration of high-margin generic drugs going forward. He went on to say that he may raise his profit expectations for the company as a result.

In the meantime, he reiterated his outperform rating on Caremark's shares.

By now, Gill has listed a number of reasons for buying the stock as well. Notably, she points to Caremark's mail-order growth and profitability per claim as the highest in the industry. Therefore, looking ahead, she expects Caremark -- a company dragged down by regulatory probes in the past -- to finally start outperforming the group.

"Caremark remains our top pick going into earnings, as we believe the recent underperformance relative to its peers is unwarranted," Gill wrote on Monday. Moreover, "we believe earnings growth at Caremark should outpace its peers in the next few years."

Word of Caution

Gill reserves her only real caution for Express Scripts, a company that has posted much better stock gains than its larger peers.

Gill worries about the company's recent contract losses -- along with the lower manufacturer rebates it has been receiving in the current environment -- as well as its near-peak valuation. She also feels that the company's back-end loading earnings guidance could be at risk.

Thus, Gill has a neutral rating on Express Scripts even though she fully expects the company to beat fourth-quarter expectations. Analysts, on average, are looking for the company to post a fourth-quarter profit of 75 cents a share next week.

In the meantime, Leerink Swann analyst Ann Hynes continues to recommend all three PBMs. Hynes has predicted solid fourth-quarter earnings for every one of the companies and, more importantly, even better things to come.

"We believe 2006 will be the best fundamental backdrop for the PBM industry," Hynes wrote on Tuesday. "Therefore, current EPS estimates for all three PBMs could prove conservative based on the solid industry tailwinds."

Hynes singles out Medco as her favorite pick in the group.

Things to Come

Gill expects good things from Medco as well. She believes the company will meet fourth-quarter expectations with profits of 61 cents a share. Indeed, she suggests that the company might even surpass that target.

She realizes that investors will be focusing especially hard on Medco's profitability metrics, given the disappointment caused by its lower-margin contracts last time around. But she sees a number of positive drivers for Medco -- and, indeed, the group as a whole -- going forward. She points to generic growth opportunities in particular.

So does Hynes.

"Increased generic utilization should be a key driver for earnings growth in 2006," Hynes has noted. "In the upcoming year, an estimated $23 billion in 2004 drug sales is at risk of generic exposure. (And) with generics generating roughly three times the gross profit of branded drugs, the possibility for significant margin expansion is real."